Financial Supervision: Comparison of the Supervisory Fees in an International Perspective

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Financial Supervision:

Comparison of the Supervisory Fees in an

International Perspective

by

Suzanne van Hoeve

Master Thesis

Submitted to the Faculty of Economics in fulfilment of the requirements

for the degree of Master of Science in Economics

University of Groningen The Netherlands

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Abstract

Recognizing the importance for the Netherlands to remain attractive to financial institutions, this paper examines how the Dutch supervisory fees charged to financial institutions are related to supervisory fees passed on to the financial sector abroad. This exercise is done across twelve EU member states. The research focuses on how supervisory fees are passed on to financial institutions and how much supervisors levy on entities. The empirical results suggest that the total charged amount of supervision costs in the Netherlands lies, in comparison with the other sample countries, slightly above average. Focusing on different segments of the financial market, the results indicate that the levied supervisory fees on credit institutions and insurers are relatively high in the Netherlands. It seems to be that a lower amount of costs passed on to banks in other countries is the result of not charging costs by the central bank. On the contrary, the charging of supervision costs to the pension sector is comparatively low. The paper also subscribes the importance of limiting entry barriers, especially for small financial institutions.

JEL Classification Numbers: G20, G28, G33, L51

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Foreword

In front of you lies my master thesis which I have written to finalise my master Economics at the University of Groningen, the Netherlands. The research, on which this thesis is based, is performed at the Financial Markets Directorate of the Netherlands Ministry of Finance. The Ministry of Finance gave me the opportunity to jump into the world of financial markets and to carry out the empirical research in the field of supervisory fees. The last five months were an intensive, but valuable experience. The assignment formed a great challenge and I really enjoyed performing this research.

Yet, the successful finishing of my thesis would not have been possible without the help of certain persons, which I like to acknowledge here. First of all, I would like to thank my supervisor of the faculty of Economics, Prof. Dr. K.H.W. Knot, and his colleague at the Dutch Central Bank, Mr. Dr. R.H.J. Mosch, who provided me with excellent comments on the draft versions. Furthermore, I would like to thank the people at the Ministry of Finance and in particular my supervisor Peter Nijsse for giving me this opportunity and letting me perform the research with such a high level of independence. Finally, I thank my friends for giving me a pleasant time during my entire study period, as well as my family for supporting me

unconditionally. Last but not least, I would like to thank my boyfriend Tom, for all his love and support. Thank you very much!

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participants in the financial markets can rely on their contracting parties being able to meet their financial obligations. The ‘Autoriteit Financiële Markten’ (AFM) supervises the conduct of business of the entire financial sector. Conduct of business supervision aims to protect consumers against bad behaviour of financial institutions.

In the Netherlands, the costs of financial supervision are both borne by the government and the supervised financial sector. However, the greater part is funded by the financial

institutions (79 percent in 20061). Charging the costs of supervision to the financial sector is based on the ‘direct benefit principle’. Categories of companies have to contribute into the costs of financial supervision to the degree to which they benefit from the public good. The costs of supervision are levied on financial institutions by means of supervisory fees. These fees are, based on proposals of the supervising authorities, annually established by the Dutch Minister of Finance.

Charging the costs of supervision to Dutch financial institutions may have a negative influence on the international competitiveness of the Netherlands. Dutch investment funds already moved to respectively Ireland and Luxembourg, and it seems to be that Belgium is trying to attract foreign pension funds. Recognizing the importance of remaining attractive to financial institutions, the main purpose of this paper is to examine how the Dutch supervisory fees are related to supervisory fees that are charged to financial institutions abroad. I will try to compare how the supervisory fee is composed and how much supervisors levy on financial institutions across twelve EU member states. Ultimately, the aim of this paper is to present a consistent global picture in the context of supervisory fees performed by different supervisors.

The paper is organised as follows. To present a balanced view of the charged

supervisory fees across Europe, sections 2 and 3 will first shed light on the benefits and costs associated with financial supervision respectively. To restrict the paper, I will mainly focus on the benefits of prudential supervision. In turn, section 4 answers the question why costs of supervision are largely funded by the private sector as ultimately the whole society benefits from it. Section 5 reports and analyses the empirical results of the comparison of supervisory fees across Europe. Section 6 concludes and recommends.

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2. Benefits of financial supervision

To assess the benefits of financial supervision we should first understand the economic rationale for supervision. Therefore, section 2.1 discusses why prudential regulation and supervision are needed to achieve a safe and sound financial system. It also emphasizes the particular role of banks in systemic and prudential supervision. As prudential supervision of the financial system is often motivated by the idea that financial system problems are costly, section 2.2 deals with the question how costly financial crises in fact are. It provides an

overview of the losses related to financial crises and proves the essential role of supervision in avoiding such crises. The costs that are avoided as a result of supervision are indicated as benefits of supervision. Section 2.3 in turn will take into account the positive effects of the quality of supervision on bank credit ratings (by Moody’s Investment Service). We shall see that higher credit ratings are another benefit of financial supervision.

2.1 Economic rationale for supervision

This section of the paper discusses why regulation and supervision are necessary to achieve a safe and sound financial system. To answer this question I will follow Llewellyn (1999) who argues that the case for regulation and supervision depends on various market imperfections and failures (especially externalities and asymmetric information) that, in the absence of regulation and supervision, produce sub-optimal results and reduce consumer welfare. I will discuss four different rationales for financial supervision that are also mentioned in the paper by Llewellyn (1999). Next, the essential role of banks in systemic and prudential supervision is taken into account.

First rationale for regulation designed to protect the consumer is to correct for market imperfections. Examples of market imperfections in retail financial services are: problems of inadequate information on the part of the consumer, agency costs (asymmetric information may be used to exploit the consumer), problems of determining the quality of a financial product at the point of purchase, and free rider problems where consumers assume that others have investigated the safety of financial institutions. To make consumers effective in the market place, a high degree of information disclosure and consumer understanding is needed. Regulation and supervision aim to enhance consumer welfare by reinforcing competition and by making them more effective in the market.

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asymmetric information features, risk-averse consumers may exit the market altogether. In its extreme form the market breaks down completely, which is called a lemons market (Akerlof, 1970). It appears to be that consumer confidence in financial institutions is greater as they are supervised. Regulation and supervision provide consumers some independent confidence about the terms on which contracts are offered, about the safety of assets and the quality of advice. An additional role of regulation is to set minimum standards to remove ‘lemons’ from the market.

Third rationale deals with economies of scale. As customers are in practice unable to undertake supervision, they in fact delegate the task to supervising authorities. There are substantial economies of scale to be secured through a collective authorisation and supervision of the financial sector.

Last economic rationale for regulation and supervision concerns potential systemic problems associated with externalities (which are a particular form of market failure). ‘Regulation for systemic reasons is warranted when the social costs of failure of financial institutions exceed private costs and such potential social costs are not included in the decision making of the firm’ (Llewellyn, 1999). The task of regulation and supervision is to ensure that financial institutions operate in a prudent manner and that they hold capital and reserves sufficient to support the risks that may arise running their business. Systemic issues traditionally have been central to the regulation of banks. The pivotal role of banks in systemic regulation and supervision is based on four main considerations:

Firstly, banks have a crucial role in the financial system because they are the only source of finance for a large number of borrowers (Bernanke, 1983) and more importantly, they manage the clearing and payments system.

Secondly, banks are possibly subject to bank runs, which may have disastrous effects for the economy. Friedman and Schwartz (1963) argue that in the United States almost every major recession between the end of the Civil War and the beginning of World War II was associated with some kind of a banking panic. Uncertainty about the health of the banking system in general may lead to runs on banks both good and bad. If nothing is done to restore the public’s confidence, a bank panic can occur. The externality is that the insolvency of one bank may cause depositors of other banks to withdraw deposits. This can cause a solvent bank to become insolvent as a large part of bank assets are not easy to sale. If a bank run occurs, the institution is forced to dispose assets which, because of asymmetric information, cannot be sold immediately as potential buyers impose a high risk premium in the purchase price.

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financial industries, which means that the failure of a bank may cause immediate losses to other banks.

Third element concerns the nature of bank (debt) contracts. Banks offer debt contracts for liquid deposits that finance the acquisition of illiquid assets of uncertain value (loans). The potential danger is that even a solvent bank may be forced to sell assets at a loss. The value of a bank’s loans is based on inside information possessed by the bank that cannot credibly be transferred in a secondary market because it is difficult for purchasers to evaluate customer-specific information. Distress selling may therefore induce insolvency in what would otherwise be a solvent bank because, owing to problems of asymmetric information, the market is unable to assess the quality of the assets being sold.

Fourthly, safety net arrangements that apply to banks (lender-of-last-resort and deposit insurance) may be associated with adverse selection and moral hazard problems. Banks may be caused to take more risks and operate with less capital if deposit insurance exists. In turn, depositors may rationally seek high-risk banks as they receive a higher rate of interest. With the existence of a lender-of-last-resort there is also a moral hazard associated: banks may be caused into more risky activity, and the appropriate risk-premium is not reflected in deposit interest rates as depositors believe that banks will always be rescued. Mishkin (2001) argues that the government need to take steps to limit the moral hazard and adverse selection that the safety net creates. Otherwise, banks will have a strong incentive to take on excessive risks that the safety net may do more harm than good.

The issues involved in macro-prudential regulation of non-banking financial firms are different from those related to banks because:

• systemic risk is considerably less evident than in banking,

• contagion is less likely because of the nature of contracts involved, • disruption of the payments system does not arise,

• as long as there is no perceived lender-of-last resort, there are no moral hazard problems,

• securities firms, for instance, hold liquid assets which can be easily traded in secondary markets. Banks have long-term commitments to their customers and are less able to adjust their balance sheets rapidly, and

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Since the banking system plays an essential role in the payments system and in the

distribution of saving, effective prudential regulation and supervision of banks is essential for securing the financial stability and efficient functioning of the economy.

2.2 Costs of financial crises

Extensive efforts of most countries to supervise and regulate their financial systems are motivated by the idea that financial system problems are costly. But how costly are financial crises in fact? Answering this question, we should be aware of the fact that systemic issues do not relate to all financial institutions equally. The role of banks as suppliers of liquidity services implies that financial distress at banks may have larger macro-economic costs than other financial institutions (Borio, 2003). Because of the significant position of banks, I will foremost take into account literature in the field of banking crises. The paper provides an overview of different methodologies and outcomes with respect to the losses of financial instability.

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Country Magnitude crisis Estimated losses or costs Australia

1989-92

Two large banks received capital from the government to cover losses. Nonperforming loans rose to 6 percent of assets in 1991-92

Rescuing state-owned banks was estimated to cost 2 percent of GDP

Finland* 1991-94

Savings banks badly affected; government took control of three banks that together accounted for 31 percent of system deposits

Recapitalization costs amounted to 11.2 percent of GDP

Japan* 1991-?

Banks suffered from sharp decline in stock market and real estate prices

Resolution costs estimated at 20 percent of GDP

Korea* 1997-?

5 banks were forced to exit and 303 financial institutions shutdown. 4 banks were nationalized.

Fiscal costs estimated at 28 percent of GDP

New Zealand 1987-90

One large state-owned bank accounting for one-quarter of banking assets experienced serious solvency problems due to nonperforming loans

The bank required a capital injection equal to 1 percent of GDP

Norway* 1987-93

Central Bank provided special loans to six banks suffering from the recession of 1985-86 and from problem real estate loans. State took control of three largest banks (85% of banking system assets), partly trough a Government Bank Investment Fund (Nkr 5 bn) and the state-backed Bank Insurance Fund had to increase capital to Nkr 11 bn.

Recapitalization costs totalled 8 percent of GDP

Spain* 1977-85

52 banks (of 110), representing 20 percent of banking system deposits, were experiencing solvency

problems

Estimated bank losses were equivalent to about 17 percent of GNP

Sweden* 1991

Five of the six largest banks, accounting for more than 70 percent of banking system assets, experienced difficulties

Recapitalization costs totalled 4 percent of GDP

United States 1984-91

More than 1.400 savings and loans and 1.300 banks failed

Cleaning up savings and loan institutions cost 3.2% of GDP

On average 10.5% of GDP

Table 1: costs of systemic (marked with an asterisk) and non-systemic banking crises in industrialized countries. (Source: Caprio and Klingebiel, 2003)

From table 1 we may conclude that costs of banking crises in high-income countries vary widely. However, transfer payments entailed as a result of banking losses are often huge, in many cases 10-20%. Caprio and Klingebiel (2003) find evidence that bank insolvencies are more costly in the developing world (on average 17.2% of GDP)2 than in industrial economies

2

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(10.5% on average). The difference may be because developed countries face smaller shocks to their banking systems. Alternatively, both the banking system and the real economy may have been better able to withstand a given shock because of more banking and regulatory systems. The latter explanation is also in line with an earlier paper written by Caprio and Klingebiel (1996). Here they conclude that better supervision might have manifested and halted problems earlier, if political forces were conducive to allowing supervisors to take on time corrective action. A weak incentive system for banks figured prominently. If they existed at all, prescribed capital to asset ratios were generally set at low levels and single borrower and other exposure limits were mostly non-existent or very lenient.

However, we have to interpret the results of Caprio and Klingebiel (2003) very cautious. First, we have to take into account that the data on losses and costs differ in the sense that some include corporate restructuring, while others relate only to the restructuring and recapitalization of the financial system. Second, the costs of banking crises do not include the burden borne by all bearers of costs. It only includes fiscal costs borne by the government.

The allocation of losses is an important part of the restructuring mechanism (Caprio and Klingebiel, 1996). Bearers of costs are shareholders, healthy banks, depositors and borrowers of the insolvent bank and the government. Losses to shareholders can be allocated through a decline or disappearance of their equity holdings. Losses to depositors arise as a result of a write-down of their uninsured deposits, through the change of their deposits into bank equity or both. Furthermore they incur losses if the government imposes interest rates that are below the market rates. Costs can be allocated to the government through central bank assistance, guarantee of bank deposits, tax losses as a result of bad loans or direct

intervention. Third, the fiscal costs reflect various types of expenditure involved in restructuring the financial system, including bank recapitalisation and payments made to depositors, either through government-backed deposit insurance schemes. These estimates may not be strictly comparable across countries and should be treated very carefully.

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banking crises, approximated by output losses. I turn to the literature in which they have used this broader methodology.

I start to consider the paper by Bordo et al (2001) who give a historical perspective on financial crisis costs. They compare the recent period with more than a century of financial crises and extend this comparison to the depth and duration of the crisis. The depth and duration of crises are quantified as the trend rate of GDP growth for the five years preceding the event. Crisis duration is measured as the number of years before GDP growth returns to the trend. The output loss is then calculated by cumulating the difference between pre-crisis trend growth and actual growth. They define a financial crisis as an episode of financial-market volatility marked by significant problems of illiquidity and insolvency among

financial-market participants and/or by official intervention to control such consequences. A banking crisis is defined as an episode in which financial distress is observed, resulting in the erosion of most or all of aggregate banking system capital, which we call a systemic banking crisis (as in Caprio and Klingebiel, 1996). Furthermore they distinguish currency crises and ‘twin’ crises (a currency and a banking crisis at the same time).

Bordo et al (2001) find evidence that over the last 100 years financial crises have grown more frequent but they have not grown more severe. The paper shows that financial crises have been followed by downturns lasting on average 2-3 years and costing 5-10 percent of GDP. Banking crises on the other hand have been less frequent since 1973 when capital controls were present. This relationship is also in line with theory. For example, in the literature on the Asian crisis of 1997-1998, the absence of capital controls permitted banks to fund themselves offshore. The banks were encouraged to do this by the fact that they were defended by a financial safety net and exchange rate guarantees (Goldstein, 1998). For banking crises the average cumulative GDP loss have been 7 percent in the fourth-quarter of the twentieth century; for twin crises this is 15.7 percent on average.

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Number of crises Average recovery time (in years)

Cumulative output loss (% of GDP) Banking crises 54 3.1 11,6 Industrial 12 4.1 10,2 Emerging 42 2.8 12,1 Twin crises 32 3.2 14,4 Industrial 6 5.8 17,6 Emerging 26 2.6 13,6

Table 2: costs of crises in lost output relative to trend (IMF, 1998)

It seems to be that the cumulative output loss is on average smaller in industrial countries than in emerging countries, which is also in line with Caprio and Klingebiel (2003) and the

commonly held view. However, for twin crises they found that the cumulative output losses are on average larger in industrial countries than in emerging countries. According to IMF (1998) this difference may result from the higher mean and variance of output growth in emerging market countries compared with industrial countries.

However, we also have to criticize the calculation method used by Bordo et al (2001) and IMF (1998). Mulder and Rocha (2000) argue that this approach will overstate output losses because pre-crisis growth tends to be unsustainably high. They also state that the calculation at the point where the growth rate returns to trend will understate the loss since the output level remains depressed for a number of years. The estimates take no account of the possible output costs (or benefits) in the post-crisis period. Hoggarth et al (2002) present a more formal explanation and conclude that the used method will underestimate losses associated with crises lasting for more than two years, since it does not recognise the reduction in the output level in previous years. Boyd et al (2004) also argue that this way of measuring is problematic. First, the level of output is typically still well below what would be predicted on the basis of pre-crisis trends, even at the point where the rate of growth has recovered to its pre-crisis value. Second, by focusing on growth rates rather than on levels, the effects of a crisis are not allowed to compound over time. Third, they argue that this method does not discount future output losses and thus aggregates magnitudes that are not

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As we saw, Bordo et al (2001) and IMF (1998) both used the divergence of output from trend during the crisis. Their focus is output growth. In contrast, Hoggarth et al (2002) sum up the differences in the level of annual GDP from trend during the crisis period. They argue that the calculations using output growth estimate the output loss during the banking crisis and not the loss in output caused by the crisis. They state that some of the estimated decline in output growth relative to trend would have occurred anyway and cannot be

logically ascribed to the crisis. That is why they focus on output levels. Their paper compares the output losses incurred during 47 banking crises (in high income countries and in medium and low income countries) using both methodologies. The results for the high-income countries are summed in table 3. This table shows a comparison between the IMF (1998) method, which estimates losses by summing up the difference between trend and actual output growth during the crisis period and the method used by Hoggarth et al (2002), which estimates losses by summing up the difference between the trend and actual levels of output during the crisis.

Country IMF (1998) method (%) Hoggarth et al (2002) (%) Currency crisis as well Australia (1989-90) 0.0 -1.4 No Canada (1983-85) 0.0 -10.5 No Denmark (1987-92) 22.3 31.9 No Finland (1991-93)* 22.4 44.9 Yes France (1994-95) 0.0 0.7 No Hong Kong (1982-83) 23.1 9.8 No Hong Kong (1983-86) 1.1 4.3 No Hong Kong (1998) 9.6 9 No Italy (1990-95) 18.2 24.6 Yes Japan (1992-98)* 24.1 71.7 No Korea (1997-)* 16.7 12.8 Yes New Zealand (1987-90) 16.0 16.3 No Norway (1988-92)* 9.8 27.1 No Spain (1977-85)* 15.1 122.2 Yes Sweden (1991)* 11.8 3.8 Yes UK (1974-76) 34.6 26.5 No US (1984-1991) 0.0 -41.9 No Average 13.2 20.7

Table 3: accumulated output losses during banking crises (Hoggarth et al, 2002)

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From table 3 we can conclude the following: although varying obviously from crisis to crisis, the output losses during banking crises in high income countries are large. According to Hoggarth et al (2002) the on average losses in high-income countries are around 20 percent of annual GDP. As we can see in the table, these losses are significantly larger than the

estimated losses by IMF (1998).

A crucial issue in measuring cost of banking crises is deciding whether costs are caused by the banking crises or whether recession caused the crises. Hoggarth et al (2002) have tried to separate declines in output during periods of banking crisis attributable to the banking crisis itself and declines due to other factors. They measure the output gaps that occurred during the crisis periods for similar countries that did not experience banking crises or at least, experience less severe ones. The idea is that the movement in output relative to trend during the crisis period would have been, in the absence of a banking crisis, the same to the movement in the pairing country. Pairs have been made for the episodes in the sample of systemic banking crises. It turns out that cumulated output losses are 25% of GDP higher in the sample of systemic crises than in the comparable non-crisis countries. So output losses during crises in developed countries appear to be larger than in neighbouring countries that did not experience severe banking problems. Also they found that banking crises but not currency crises significantly affect output in developed countries. A shortcoming of the paper by Hoggarth et al (2002) is that they assume that all output losses associated with a crisis have been incurred by the time the crisis is over.

Other studies have employed cross-sectional regressions to estimate the relationship between banking crises and costs. Among them are Demirgüç-Kunt et al (2006), who estimate cross-country regressions using a sample of 36 crises in 35 high and low income countries. They study especially what happens to the banking system following a banking crisis. The most interesting result of the paper is that crises are not accompanied by a significant decline in bank deposits relative to GDP. The paper suggests that depositors leave weaker banks for stronger ones. So depositor panics have not been a major element of banking crises. From this we can conclude that the aggregate decline in bank deposits is not a good proxy for costs of banking crises.

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collapse in bank lending. However, interestingly is that in the second and third year following the crisis, when output growth returns to its pre-crisis levels, credit growth remains depressed.

After considering literature in the field of costs of financial crises, we find a

remarkable diversity of experience, both in lost output and in the fiscal costs to recover the unstable financial climate. Nevertheless, it appears to be the case that crises exacerbate subsequent output losses and that costs may be extremely large. Based on the measuring method used by IMF (1998) and Bordo et al (2003) I estimate the lost output associated with banking crises in industrialised countries to be on average around 10 percent of GDP (not indicating that these costs are caused by the crisis). These large costs associated with crises create an important role for supervision on systemic grounds. While the probability that the insolvency of a single bank will cause a systemic problem may be very low, if it were to occur it would be serious, and the costs would be high. As I mentioned, Caprio and Klingebiel (1996) argued that better supervision might have manifested and halted banking problems earlier. Also Bordo et al (2001) stated that banking crises have been less frequent since 1973 when capital controls were present. Assuming that prudential supervision avoids costs associated with financial crises, we can conclude that prudential supervision benefits individuals, institutions and the whole society.

2.3 Bank credit ratings

In this section of the paper I will discuss the effects of financial supervision on credit ratings. Credit ratings assess the credit worthiness of individuals, companies or even countries. They are a useful tool not only for the investor, but also for the entities looking for investors. A credit rating can put a security, company or country on the global radar, attracting foreign money and boosting a nation's economy.

Moody’s Investors Service, one of the largest credit ratings agencies operating world-wide, incorporates factors such as quality of banking supervision and external support into its methodology for bank credit ratings. As Moody’s includes such factors into its methodology, I will concentrate on these credit ratings here. The aim of this section is to demonstrate that financial supervision and external support eventually may benefit individuals, institutions and countries in the way of higher credit ratings.

First question is why Moody’s includes the quality of supervision into its methodology for bank credit ratings? The reason is that they believe that the financial strength of banks is often improved with the existence of independent banks regulators with credible and

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supervision. Through a combination of effective regulations, active supervision and aggressive and on time enforcement, a strong regulatory environment can promote sound banking practices and limit extreme risk taking. Moody’s believes that without active

supervision, even the strictest standards may not prove effective. They therefore consider the frequency, thoroughness, and length of on-site inspections and the quality, depth and size of the supervisory staff. They also take into account the use of targeted inspections and loan portfolio reviews and the extent to which there are regular discussion meetings between the regulator and banks that enable supervisors to better assess specific risks and emerging risk exposures in order to have early warnings of deterioration at either an individual bank or a systemic level (Moody’s Investors Service, Bank Financial Strength Ratings: global methodology, 2007).

Recently (February 2007), Moody’s updated the methodology for its Bank Financial Strength Ratings (BFSRs). BFSRs evaluate the stand-alone or intrinsic financial strength of banks without reference to external support factors. This proposal was made in connection with a proposal to incorporate joint-default analyses (JDA) into its bank ratings to reflect external support that may benefit bank creditors. JDA was implemented to increase the transparency of Moody's bank ratings. It considers financial strength along with any support companies may get from government and financial institutions if they get into serious trouble. JDA reflects national government support as well as other major forms of external support such as parental support, support from regional and local governments and cooperative and mutualist groups.

BFSRs are the starting point of Moody's bank credit analysis, and are an important determinant of Moody's bank deposit ratings. They are a measure of the likelihood that a bank will require support from third parties such as its owners, its industry group or official

institutions. Factors considered are bank-specific elements such as financial fundamentals, franchise value, and business and asset diversification. They also include risk factors in the bank’s operating environment, including the strength and prospective performance of the economy, the structure and relative fragility of the financial system and, most importantly here, the quality of banking regulation and supervision.

BFSRs exclude certain external credit risks and credit support elements that are addressed by Moody’s bank deposit ratings. Starting with a bank's BFSR, the methodology uses Moody's rating for each relevant support provider, together with estimates of the

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opinion of relative credit risk. They consider a bank’s ability to repay punctually its deposit obligations. It includes intrinsic financial strength and both implicit and explicit external support elements.

As mentioned above, Moody’s updated its BFSRs and incorporated JDA into its methodology. However, after publishing the new bank deposit ratings Moody’s received much criticism. Due to the inherent uncertainty of non-explicit government support, market participants preferred a rating system that places greater emphasis on intrinsic credit

fundamentals. That is why Moody’s published refinements to its bank rating methodology, where assumptions about external support levels were reduced. So in the recent methodology Moody's uses conservative support assumptions and a limited number of support levels to ensure that sufficient weight is given to a bank's intrinsic financial strength in its bank deposit ratings.

Despite the refined methodology, where less weight is placed on external support, there are still observable differences in the BFSRs and bank deposit ratings before and after implementation of JDA. To give an indication of the differences, I have plotted the average BFSRs and long term bank deposit ratings before and after implementation in figures 1 and 2 respectively. To calculate the average bank credit ratings for all individual countries I

transformed both ratings to a numeral ranking (see tables 2 and 3 in the appendix). Subsequently I calculated the average bank credit rating per country.

0,0 2,0 4,0 6,0 8,0 10,0 12,0 AT BE ES FI FR DE IE LU NL PT SE UK US Average BFSR Jan 2007 Average BFSR May 2007

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0,0 2,0 4,0 6,0 8,0 10,0 12,0 14,0 AT BE ES FI FR DE IE LU NL PT SE UK US

Average LTOR Jan 2007 Average LTOR May 2007

Figure 2: Average long term bank obligation rating (LTOR) before and after implementation of JDA (January and May 2007) (Source: Moody’s Investors Service)

In figure 1 we can see that for most countries the average BFSRs decreased after updating the methodology for BFSRs and the implementation of JDA. This has happened as a result of the exclusion of external support factors. From figure 2 it appears that the average long term bank obligation ratings obviously increased for all countries. The higher long term bank obligation ratings reflect systemic support. It may be obvious that the implementation of JDA and including external support affects credit ratings in a positive manner.

From the described methodologies of BFSRs and the bank deposit ratings including JDA we may conclude that supervision and external support both affect bank credit ratings in a positive manner. In addition, credit ratings also affect the debt and equity decisions of a financial firm. Higher credit ratings lower a company's cost of raising money by signalling to lenders and investors that they face less risk. As a result, firms will face lower funding costs. More formally, Graham and Harvey (2001) find evidence that credit ratings are the second highest concern for CFOs when determining their capital structure, with 57.1% of CFOs saying that credit ratings were (very) important in how they choose the appropriate amount of debt for their firm. Kisgen (2006) find that firms near a ratings change issue approximately 1.0% less net debt relative to net equity annually as a percentage of total assets than firms not near a ratings change.

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environment and a more transparent capital market. Recognizing the importance of credit ratings, a higher quality of regulation and supervision will benefit financial institutions and even the whole country in the form of higher credit ratings.

3. Costs of financial supervision

After considering the benefits of financial supervision we should be aware of the fact that regulation and supervision do involve costs as well. Edwards and Scott (1976) argue for example that most solvency regulations have ambiguous effects on bank solvency. Capital and liquidity requirements seem to be the most effective devices to increase bank soundness. However, measures such as entry and activity restrictions may have negative results. In this section I will briefly discuss the different types of costs involved in regulation and

supervision. The purpose of this section is not to estimate the costs in a quantitative way, but mainly to show that we should be aware of these costs as they can be considerable.

Alfon and Andrews (1999) distinguish regulation costs into direct costs, compliance costs and indirect costs. Direct costs are defined as costs concerning designing, supervising and enforcing regulations. These costs are costs of the regulatory body and are closely related to the regulator’s internal organisation. To give an indication of the different direct

supervision costs involved, figure 3 demonstrates the division of supervision capacity over the main prudential supervision activities carried out by the Dutch Central Bank (DNB). The activities are divided into seven categories, namely:

1) collecting information,

2) judging the collected information by means of the standards, 3) intervention of supervised financial firms crossing the standards, 4) licensing (to enter the market),

5) correction of the standards when activities are carried out by illegal financial institutions,

6) contribution to the setting of regulation within the legal framework, and

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Collecting inf ormation 33% Judging information 31% Intervention 4% Licensing 4% Correction 3% Setting of regulation 14% Communication of regulation 11%

Figure 3: division of supervision capacity over the main activities of prudential supervision (Source: DNB, 2005)

From figure 3 it appears that the Dutch prudential supervisor spends 25 percent of its

supervision capacity on setting and communicating regulation (policy-related activities) and 75 percent on carrying out tasks of supervision.

Compliance costs are the costs to firms and individuals of those activities required by regulators that would not have been undertaken in the absence of regulation. These include not only the costs of personnel and systems required to provide information to regulators, to perform internal checks on compliance and to carry out ‘form filling', but in addition, the income from business lost as a result of the costs imposed by regulation. A reliable estimation of the compliance costs has appeared to be very difficult, especially because it is quite hard to indicate which costs financial institutions would have made anyway (with or without financial regulation). For the Netherlands the administrative costs for the financial market as a result of financial legislation of the Ministry of Finance were estimated to be €678 million for the year 2002.3 For 2007 these costs are estimated to be €550 million (temporary figure).

Least obvious costs are the indirect costs which concern negative market impacts. It are these wider macro economic costs of regulation that are both more difficult to calculate and likely to be much larger (Mayes, 2004). Indirect costs of regulation are for instance:

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• Costs as a result of suppliers that are prevented from competing with established firms: consumers and the economy may face costs from the absence of less costly products. Consumers have a lesser possibility of being offered better alternatives as a consequence of restraints on new entrants (Benston, 1999).

• Costs of imposed uniformity, for example the welfare loss associated with foregone purchases or purchases of items that scarcely meet the purchaser’s requirements (Alfon and Andrews, 1999).

• Costs as a result of regulatory escalation: regulation may become excessively burdensome over time. Goodhart et al (1998) point out that, because consumers do not pay explicitly for regulation, it is seen as a ‘free’ good. If regulation is seen as costless and regulators are risk-averse, there is an evident danger of regulation being over-demanded. When regulation is ‘excessive’ or focuses upon

inappropriate objectives, avoidable costs are imposed on the society, and these costs might exceed the economic costs that regulation is designed to avoid (Llewellyn, 1999).

• Forced choice on consumers: consumers might choose not to pay for regulation if they had this option (Goodhart et al, 1998).

• Costs associated with moral hazard of implicit contracts; the consumer believes more protection is offered than is in fact the case. As soon as a system of actual or expected bail out or insurance exists this may lead to moral hazard. Depositors who are insured may no longer take such trouble to check that the bank is being managed prudently. Also banks and their shareholders will be less concerned if they think the bank will be bailed out. This moral hazard will then increase the chance of banks reaching the point of bankruptcy (Mayes, 2004).

• Restrictions on lending opportunities may restrain the process of economic development. Subsequently, this will lead to lower income and wealth per capita than is otherwise possible (La Porta et al, 1997).

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4. Private versus public financing

Last two sections dealt with the benefits and costs associated with financial supervision respectively. Section 2.1 argued that regulation and supervision enhance consumer welfare by reinforcing competition and by making consumers more effective in the market. This will benefit both the consumer and the financial industry. Taking this point of view, financing of supervision by the financial institutions - who would pass on the bill to their customers - would seem to be desirable. However, in section 2.2 we saw that the whole society benefits from prudential supervision in the form of limited losses attributable to financial crises. This would make a case for tax-financed financial supervision.

As mentioned in the introduction, in the Netherlands the costs of financial supervision are funded by the state and the supervised financial sector (who contribute around 20 and 80 percent respectively). The question rises why the direct costs of supervision are mainly

charged to the financial sector as ultimately the whole society benefits from it? To answer this question section 4.1 will start to consider the ‘direct benefit principle’, on which the costs of supervision are levied to the private sector in the Netherlands. In addition, section 4.2 discusses some other rationales for charging supervision costs to the financial sector.

4.1 Direct benefit principle

Permission and enforcement costs are public costs for carrying out legislation related to compliance of the prevailed standards. ‘Maat Houden’ (Dutch Ministry of Finance4) provides a framework for charging the costs of permission and enforcement to the private sector (civilians, companies). It establishes in which cases and to what extent these costs may be charged. As financial supervision costs are part of the permission and enforcement costs, they are charged to financial institutions based on the framework in Maat Houden. I will discuss this framework in more detail. Maat Houden divides four costs categories:

1) permission costs (e.g. licences, exemptions and certificates), 2) post-permission costs (extension of the permission),

3) costs of preventive enforcement, and 4) costs of repressive enforcement.

Preventive enforcement can be described as supervision activities that take place at random.

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They are not announced and are aimed at observance and prevention of violations. Repressive enforcement is considered as supervision activities that are based on a suspicion of a penal offence or the violation of the administrative law and are followed by a charge or by an imposed sanction. For all cost categories, Maat Houden examines whether the cost have to be financed by public funds, by the private sector or by both. Charging these costs to the private sector is based on the ‘direct benefit principle’: the more civilians and companies benefit from a publicly provided good, the more they have to contribute to the costs of these goods.

The theory of public finance gives hold in answering the question which costs of permission and enforcement may be charged to private participants and which costs not. In the literature they make a distinction between ‘pure public goods’ and ‘quasi-public goods’. A pure public good is non-rival which means that consumption of the good by one individual does not reduce the amount of the good available for consumption by others. Pure public goods are also non-exclusive which means that it is not possible to exclude individuals from consumption of the good. Examples of pure public goods are the administration of justice and dikes. These goods are difficult to be delivered by the market and are fully financed by the taxpayer. Quasi-public goods are not exclusive since users of the goods are identifiable. An example of a quasi-public good is higher education. Quasi public goods are also provided by the government, despite the fact that they can be delivered by the market. Costs of quasi-public goods can be partially or fully charged to the private sector, as the user who benefits from the good is (partially) identifiable.

We can conclude that if permission and enforcement activities are attributable to the direct benefit principle, they are quasi-public goods and are chargeable. The private sector has to contribute into the costs of permission and enforcement to the degree to which it benefits from the goods.

Now I turn back to the four costs categories to discuss whether they are chargeable or not. Obviously, permission and post-permission activities are quasi-public goods as the user of the good is identifiable. In addition, the direct benefit principle is important here because the user has an identifiable benefit of the permission or post-permission. That is why it is possible to pass on these costs to an individual citizen/company or a group of

citizens/companies. In the Netherlands, supervision costs related to permission and post-permission activities are fully charged to the financial sector. We can pass on these costs as the activities deliver a direct identifiable benefit to the financial institution (a quasi-public good). This corresponds to the framework presented in Maat Houden.

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p56) states that these goods are pure public goods. They are not easy accountable to identifiable users. As a result, the framework argues that preventive and repressive enforcement costs may not be charged to the private sector, unless:

• the aim of the legislation is only reached by charging; • the rules are imposed by European legislation;

• participants have an identifiable benefit from the preventive enforcement activities (there are distinguishable sectional interests to a specific group of

citizens/companies)

• there are offenders who (almost) entirely cause the costs of repressive enforcement.

Maat Houden emphasizes that preventive supervision costs may not be financed totally by private funds, since there is always a public interest.

In the Netherlands, the repressive costs of supervision are totally funded by the state. Repressive supervision activities are for instance the supervision of market manipulation as well as fighting illegal practices. These goods are pure public goods. They deliver a public interest and are therefore not charged to the financial sector, which is in line with Maat Houden.

Finally, I will analyse the preventive supervision activities which are focused on prevention of violations. In the Netherlands, the costs of preventive supervision are funded by the financial market and by the state. Preventive costs resulting from the ‘Reporting

Uncommon Transactions Act’ (Melding Ongebruikelijke Transacties), the ‘Services Identification Act’ (Wet Identificatie bij Dienstverlening) and the ‘Sanctions Act’ are financed by the state. If we apply the framework in Maat Houden to the preventive supervision costs, these costs may only be charged to the financial sector when there are distinguishable sectional interests for this group. Following the paper by Llewellyn (1999) there are several ways in which the financial industry might benefit from supervision:

• Supervision enhances competition and efficiency in the financial sector through which everyone can gain.

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• To the extent that badly behaving financial firms are removed, the reputation of the whole industry is enhanced.

• In the case of prudential supervision, financial firms’ own counterparty risks should be reduced.

It should be obvious that preventive supervision delivers a distinguishable sectional interest to financial institutions. Market participants do have an identifiable direct benefit and preventive costs may be charged to (categories of) financial institutions.

After analysing whether the different cost categories are applied correctly to the direct benefit principle, it might be clear why supervision costs are charged to the Dutch financial market. However, the framework in Maat Houden does not foresee in all charged supervision costs. For example, costs that are made by supervisors to support legislation processes are rather difficult to apply to the direct benefit principle, but are nevertheless passed on to the financial sector. If support of the legislation process goes further than its normal

recommending role concerning new legislation, the state should finance the accompanied costs.

4.2 Other principles for industry financing

Besides beneficiary-considerations there are some other grounds for passing on the costs of supervision to the financial sector. Given a particular budget constraint, accountability

provisions should ensure that the supervisor manages its resources in a cost-effective manner. Accountability requires ‘at the very least that the agencies explain and justify their actions and decisions and give account in the execution of their responsibilities’ (Lastra and Shams, 2001). Every year the supervisors are obliged to draw up an estimate which is monitored by the Netherlands Ministry of Finance. The supervising authorities have to justify the costs that are levied on supervised financial entities. Charging costs of supervision also creates more transparency since supervisors annually have to invoice these costs. As the financial institutions pay for the public good, they have the right to know what kind of supervision activities are carried out. We can conclude that charging the costs of supervision lowers losses of efficiency and increases the transparency of costs.

An additional advantage of industry financing is that fees could be risk-based. This creates an instrument for the supervisor to steer the financial firms into a particular

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combination of scheme and risk-based factors. Pension funds with an undesirable funding (from the perspective of the supervisor) contribute relatively more than pension funds with a ‘healthy’ funding. Another example is that banks that have a high risk profile and need more monitoring pay more for any given balance sheet size.

5. Comparison supervisory fees across Europe

After considering why supervision costs are largely funded by the financial sector in the Netherlands, it is time to analyse how supervisory fees are charged to financial institutions and how much supervisors levy on entities. I will do this exercise across twelve European countries5. The data are directly obtained from the regulatory agencies and/or ministries in the sample countries. I carried out a survey which contained questions about the source of

financing and supervisory fees. Comparing supervisory fees is a comprehensive task, as the organisation of financial supervision differs across countries as well as the tasks of

supervisors. Also differences in nature and scale of the financial sectors across Europe make it difficult to compare. The aim of this section is to present a consistent global picture in the context of supervisory fees by different supervisors across Europe.

This section is organised as follows. Section 5.1 will start to compare whether and how supervisors charge fees to the financial sectors in the different countries. I will focus on the underlying fee structures that the different supervisors use to cover the costs of

supervision. In addition, section 5.2 will focus on the amount that supervisors levy on entities, taking into account several segments of the financial market (credit institutions, insurers, pension funds and investment funds). Most important question to answer is how Dutch supervisory fees are related to supervisory fees charged to the financial sectors in other countries.

5.1 How do supervisors charge their supervision costs?

Section 5.1.1 presents a cross-country overview of the relevant fee structures that supervisors use to finance their supervision costs. To be considered is how the supervisory fee is

composed (e.g. fixed minimum fee and proportional fee) and whether the fee structure is characterized by a degressive, linear or progressive fee. Subsequently, section 5.1.2 will compare and evaluate the characteristics of the different fee structures. For example I will

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examine whether countries use a very broad classification into different ‘fee blocks’ or a specified one (as in the Netherlands). Also the barriers that supervisory fees can create for financial institutions are taken into account.

5.1.1 Supervisory fee structures: a cross-country overview

The different supervisory fee structures for Belgium, Finland, Ireland, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the UK are enclosed in the appendix (tables 25-38). Note that these fee structures concern the continuous supervisory fees and not the application fees. The manner in which Germany charges its supervision costs is described below. Data about the way the Austrian and French supervisors calculate their fees is (largely) lacking. Now the overview of the relevant supervisors and their way of charging is given:

In Austria, the entire financial market is supervised by the Austrian Financial Market Authority (FMA). In the field of banking supervision the FMA is assisted by the

‘Oesterreichische Nationalbank’ (Central Bank of Austria), which conducts on-site

inspections and certain examinations of credit and market risks of banks. About 85% of the supervision costs are borne by the supervised institutions. The federal government contributes a flat amount of €3.5 million per fiscal year. The total costs (minus the Republic’s

contribution and minus fees charged directly for certain services) are proportionally charged by the FMA to the supervised institutions. Directly charged fees for certain services mostly result from the area of banking supervision and are to a very large extent investment fund fees.

The ‘Commissie voor het Bank-, Financie- en Assurantiewezen’ (CBFA) is the supervisor of the Belgian financial services sector. The costs of the CBFA are fully covered by financial institutions under supervision. The Belgium supervisor levies a pre-payment on financial institutions and at the end of the year there is a regularization of the contributions, because the financial firms only have to pay for the actual supervision costs. A surplus (which is most common) is either refunded the next year or deducted of the contributions of next year. In case of a shortage a complementary contribution is asked. CBFA charges fixed fees, fees based on a global base per sector, or a fixed fee complemented with a fee based on a global base per sector. Besides CBFA, the Securities Regulation Fund (‘Rentenfonds’) is an independent public institution that supervises the off-exchange market in linear bonds, split securities and Treasury certificates of the Belgium state. The Securities Regulation Fund does not charge any supervisory fees to supervised institutions.

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administratively in connection with the Bank of Finland, but is an independent decision-making body. RATA is totally funded by supervision fees and periodic fees, which are paid by supervised entities and issuers of securities. The periodic fee exists of a basic fixed fee, a proportional fee or a combination of the two. The proportional fee is just a percentage of the tariff base (there are no different tariff bands). As a result, the proportional amount increases linearly with the size of the tariff base (which is comparable with a ‘flat tax’). The basis of the proportional fee is the balance sheet total, annual turnover or total value of managed mutual funds. The Insurance Supervisory Authority (ISA) is responsible for supervising the insurance and pension sector. The ISA imposes both a fixed and a proportional fee to insurers and pension funds. Also the costs incurred by the ISA are covered by supervision and procedural fees collected from the supervised institutions.

In France the ‘Commission Bancaire’ (CB) and the ‘Comite des établissements de credit et des enterprises d’investissement’ (CECEI) are authorized to supervise banks. The costs of supervising banks are financed by public funds. Banks do not contribute into the costs of supervision. The ‘Autorité des Marchés Financiers’ (AMF) is in charge of the supervision of issuers and financial intermediaries and infrastructures. Data about the fees that are charged by AMF is lacking. The ‘Autorité de contrôle des assurances et des mutuelles’ (ACAM) and the ‘Comite des entreprises d’assurance’ (CEA) are responsible for supervision of insurance companies and pension funds. ACAM levies fees on insurance undertakings. The charge allocated to insurance companies is based upon their sales revenue. In 2007, insurance undertakings will be taxed on their 2006 sales revenue at 0.0012 %. Funding of CEA is derived from the state budget.

The ‘Bundesanstalt für Finanzdienstleistungsaufsicht’ (BaFin) is the German supervising agent of the financial market. In addition, BaFin cooperates closely with ‘Bundesbank’ to supervise the banking sector. As well as performing day-to-day on-sight supervision, the Bundesbank is responsible for analysing prudential returns and audit reports and maintaining the credit register for loans. Furthermore, the Bundesbank is involved in drafting prudential legislation in order to ensure a stability-oriented regulatory framework. Bundesbank only charges fees for onsite-inspections.

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allocated are the actual budget expenditures of BaFin and the Auditing Agency for one budget year. BaFin establishes the allocation rates on the basis of its annual balance sheet. In order to cover the supervision costs they levy a pre-payment on financial institutions, which has to be paid in two terms (January 15 and July 15). Then, in the subsequent year the actual costs are determined and deducted with the pre-payments. BaFin’s total expenditures of one financial year are distributed separately among the ‘banking and financial services industry’, the ‘insurance and pension funds industry’ and the ‘securities industry’. However, it may be possible that financial institutions are consulted for several groups. For example, it can occur that insurance companies are issuers at the same time and costs are thus allocated for the supervision groups ‘insurance’ and ‘security nature’. I will explain the allocation of costs to the three categories in more detail now:

Firstly, the charges for banking institutions and financial services institutions are based on the relationship between the individual balance sheet total of the liable entity and the total amount of all balance sheet totals of the enterprises in the industry.

Secondly, the proportional fee for insurance institutions is based on rough payments (gross premiums, contributions, pre- and additional payments and reallocations). For pension funds the fee is based on pension fund contributions.

Thirdly, the securities sector is subdivided into credit institutions, intermediaries, financial services institutions and issuers (who bear respectively 76%, 5%, 9% and 10% of the costs allocated to the securities sector). The base of the levies allocated to credit institutions and intermediaries is the announced business of the individual supervised institution related to the announced business of the whole industry. The rate for financial services institutions is based on the relationship between the total balance sheet of the individual firm and the total amount of all balance sheet totals of all firms in the industry. Finally, costs are charged to issuers based on the turnover of the firm compared to the turnover of the whole supervised industry.

For all institutions yield that the allocation amount must be at least €250 and not in excess of €15.000. The minimum fee for credit institutions (excluding securities trading banks) amounts to €4.000. However, a credit institution with a balance sheet total below 100 million euro has to pay a minimum fee of €3.500. The minimum fee for companies in the insurance and/or securities industry is €250.

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partially funded by the state and partially by the financial market. Over the three year period 2004-2006 approximately 50 percent of the total costs of the financial regulator are to be met by the imposition of levies on the industry6. IFSRA does not impose any other charges than the annual industry funding levy. There are no authorisation fees, permission costs, licence fees etc. The fee system of IFSRA is characterized by a fixed fee and a proportional fee. The fee to be paid is the total of the sums payable for each of the tariff bands applicable to the firm’s business, calculated by a relevant minimum fee plus an additional fee. The additional fee is calculated by multiplying the firm’s tariff base by the appropriate rates applying to each part of the tariff base. The fees are based on a degressive system: when the base of the

proportional fee increases, the charge decreases. As a result, large companies pay relatively less than smaller companies. However, very small financial firms do not have to pay the additional fee (a zero-tariff rate applies to the first band). The Pensions Board (TPB) is in charge of supervision of the pension funds in Ireland. TPB does only charge a proportional fee.

In Luxembourg the ‘Commission de surveillance du secteur financier’ (CSSF) is in charge of the supervision of the financial sector, with the exception of the insurance sector and certain types of pension funds. The ‘Commissariat aux Assurances’ (CaA) is responsible for supervision of the insurance sector and certain types of pension funds. CSSF charges only fixed fees. As a result, small firms pay relatively more than large ones. In the appendix only the fees collected by CSSF are included.

The Dutch supervisory system is characterized by two supervisors who differ in nature of supervision. ‘De Nederlandsche Bank’ (DNB) is the authorized prudential supervisor and the ‘Autoriteit Financiële Markten’ (AFM) is the authorized conduct of business supervisor. The Netherlands apply mixed public-private funding of supervision by both authorities. Fees of DNB and AFM are calculated by a relevant minimum fee plus an additional fee (the total of the sums payable for each of the tariff bands). The fee structures are characterized by a degressive payment system.

In Portugal, the ‘Banco de Portugal’ (BdP) is the supervisory authority of credit institutions, investment firms and financial companies, whereas the Portuguese Insurance Institute (ISP) is responsible for prudential supervision of insurance companies and pension fund management companies. Moreover, the ‘Comissão do Mercado de Valores Mobiliários’

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(CMVM) is responsible for supervision of financial intermediaries in the securities market. BdP does not charge any supervisory fees. However, the CMVM is fully funded by the private market. CMVM levies fees due by all financial intermediaries as payment for the services concerning ongoing or prudential supervision, and fees for the services provided by CMVM, namely the granting of authorization for, approval, or registration of acts,

dispensations or other acts performed by CMVM. For continuous supervision, the supervised financial institutions must pay a monthly fee. CMVM uses fixed fees or proportional fees (as a percentage of the base). ISP in turn charges fees which are paid annually. For insurance undertakings and pension fund management entities, the Minister of Finance establishes annually the percentage that will constitute the fee, taking into account the ISP’s proposal based on its estimate annual budget and the predictable evolution of the insurance and pension fund market.

In Spain, the financial sector is supervised by ‘Banco de España’, ‘Dirección General de Seguros y Fondos de Pensiones’ (DGSFP) and ‘Dirección and Comisión Nacional del Mercado de Valores’ (CNMV). The Banco de España supervises the solvency and specific regulatory compliance of credit institutions. DGSFP is integrated in the Ministry of Economy and is responsible for supervision of the insurance and pension funds sector. CNMV is the agency in charge of supervising and inspecting the Spanish stock markets and the activities of all the participants in those markets. Only CNMV charges supervisory fees to its institutions under supervision. Their fee system is characterized by proportional fees. Only members of stock markets and members of secondary markets pay a progressive fee. This means that the more number of operations by members in the stock market or secondary market, the more these members relatively have to pay for supervision. The progressive fee brings along that the trade barriers for small participants in these markets are low. However, since large participants in the market pay relatively more, it does not stimulate members to purchase or sell more.

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fee is the sum payable for each of the tariff bands applicable to the firm’s business (as a percentage of the tariff band). FI uses a maximum rate of percentage of reported balance sheet which could be charged and a minimum amount to charge.

In the United Kingdom, the Financial Services Authority (FSA) is responsible for supervision of the financial services sector. FSA is entirely funded by fees levied on the financial services industry. These fees are generally set according to a structure of ‘fee-blocks’, each of which applies to a different sector of the financial services industry. This structure aims to recover the costs of regulating each sector and is characterized by degressive fees. In addition, the Pensions Regulator is the UK regulator of work-based pension schemes (occupational schemes and stakeholder and personal schemes where employees have direct payment arrangements). The Pensions Regulator’s levy is based on the total number of members in the scheme at the end of the scheme year before last. The amount to be paid depends on the band which the scheme falls into and may be subjected to a minimum fee. Besides the Pensions Regulator’s levy, pension schemes have to pay an administration levy and a Pension Protection levy (these fee structures are not included in the appendix). The Pension Protection Fund (PPF) pays compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer, and where there are insufficient assets in the pension scheme to cover Pension Protection Fund levels of compensation (www.pensionprotectionfund.org.uk). To fund the Pension Protection Fund, compulsory annual levies will be charged on all eligible schemes. The Pension

Protection levy is based on a combination of scheme and risk-based factors. The scheme-based element must take account of the level of a scheme’s liabilities relating to members. The risk-based element must take account of the funding level of a scheme and, in some cases, the risk of the sponsoring employer becoming insolvent.

5.1.2 Analysis of different fee structures

After describing the different ways of charging I will summarize the major findings and subjects for debate:

Role of the central bank

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is that the banking sectors in Spain, Portugal and France are all supervised by the central bank and not by a separate supervising authority. These central banks have mainly banking

supervisory functions, but are also involved in monetary policy issues. Therefore, a

conscientious contribution of costs is difficult and costs are not charged to the private sector. However, in the Netherlands, where the central bank is the prudential supervisor, and in Ireland, where the supervisor is an autonomous entity within the central bank, banking supervision costs are mainly charged to the private market (around 80 and 50 percent respectively). In all other countries there exists a separate banking supervisor besides the central bank, which is totally funded by the financial sector (except in Austria, where 85 percent of the costs of the separate supervisor is passed on to the private sector).

It seems to be that there is a connection between the role of the central bank and the funding of supervision costs. Where the central bank is the supervisor, the costs are often financed by public funds, whereas separate financial supervisors are largely financed by private funds. This result is also in line with the recent findings of Masciandaro, Nieto and Prast (2007). They focused on financing of banking supervision across 90 countries worldwide and found evidence that full public financing is the most common budgetary arrangement where central banks are banking supervisors, while supervision funded via a levy on the supervised banks is more likely in the case of a separate financial authority.

The question rises whether there is a likelihood of unfair competition in the financial markets across Europe. If one country charges all its supervision costs to the private sector and the other country does not, the competitiveness of financial markets across countries may be in danger. Is there a task for Brussels to implement an integrated system of supervisory fees across Europe?

Fee structure

Secondly, comparing the fee structures, it seems to be that many countries calculate their fees by adding a fixed minimum fee and an additional variable fee. Most divergent is the fee structure used by CSSF in Luxembourg, who apply a system of fixed fees only. As we can see in the appendix, Luxembourg only takes into account financial firms with multiple

departments and only credit institutions are liable to an additional fixed fee attributable to a share of their total balance sheet. A negative consequence of such a system is of course that small firms relatively bear more into the cost of supervision than large ones.

Financial Supervision: Comparison of the Supervisory Fees in an International Perspective